Health care groups urged to diversify investments

Health care organizations should adopt a new endowment model that reduces their reliance on fixed income assets such as bonds and cash, and increases allocations to alternative investments and other illiquid assets, a new white paper says.

The new model was developed over three decades by educational institutions and increasingly adopted by other types of nonprofits, and shifting to it and reaping benefits from it could take decades, making that shift “all the more urgent,” says Assessing the State of Healthcare, the white paper from the Commonfund Institute.

“It is in the interest of health care organizations, rating agencies and donors that health care endowments evolve toward becoming more like those of other long-term nonprofit institutions,” the white paper says.

Nonprofit health care organizations typically operate with “razor thin margins, or even at a deficit, the paper says, and they get revenue from reimbursement from government, by far the biggest source, and from income from private insurers and self-pay patients, and through support from donations or transfers from endowments they may have.

Any excess of reimbursements and income from insurers and patients over costs represents the “operating margin” for these organizations.

A 2012 Commonfund study found that, among 86 nonprofit health care organizations surveyed, the median operating margin in fiscal 2011 was 4.1 percent, up from 2.9 percent in fiscal 2008.

The increase reflects cost cutting across the industry, with big health care organizations making the greatest progress but smaller organizations catching up.

Large organizations made early progress “because they realized they would have to reduce operating expenses and took steps to change their cost structures to capture greater economies of scale.”

Smaller health care organizations followed the lead of those bigger organizations, taking “what actions they could to lift their previously low — and even negative — operating margins.”

But because bigger groups can spread cost reductions over a wider base of patients and constituents and weather reimbursement reductions the paper says, they will reap greater benefit than smaller and mid-sized groups with proportionately higher fixed costs.

Those smaller and mid-sized organizations will rely more heavily on endowments to “enhance surpluses and make up for losses,” the paper says.

Most health systems use bond issues to fund construction projects and improvements, it says, and successful bond offerings depends in large part on the bonds earning a high rating from bond rating agencies.

And bond agencies “look not only to the ability of the health care provider to generate cash flow but also to the liquidity of its endowment’s financial assets as a potential backstop source of repayment,” the paper says.

As a result, it says, assets allocations of health care endowments tend, on average, to be weighted more heavily toward cash and fixed income investments than those of other types of nonprofits.

And that bias away from traditional equity investments generally have returned less per year than other nonprofits, the paper says.

“This practice seems increasingly to resemble a luxury that will eventually become unsustainable as other sources of revenue for health care organizations continue to diminish,” it says.

While allocations to fixed income investments and cash total nearly 40 percent of the portfolio of the average nonprofit health care organization, the paper says, health care organizations are better off with more highly diversified portfolios, managed “with prudent regard to liquidity,” to support bond repayment.

For small and mid-sized health care organizations that “lack the ability to spread costs over a wider patient base,” the paper says, “a greater degree of reliance on endowment income appears inevitable, and there is little time to lose.”

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